Income Investing
By Steve Selengut, Thu Dec 8th

When is 3 percent better than 6 percent? Yeah, we all know theanswer, but only until the prices of the we alreadyown begin to fall. Then, logic and mathematical acumen disappearand we become susceptible to all kinds of special cures for theperiodic onset of higher interest rates. We'll be told to sit incash until rates stop rising, or to sell the we ownnow, before they lose even more of their precious Market Value.Other gurus will suggest the purchase of shorter-term bonds orCDs (ugh) to stem the tide of the perceived erosion in portfoliovalues. There are two important things that your mother nevertold you about Income Investing: (1) Higher Interest Rates aregood for investors, even better than lower rates, and (2)Selecting the right to take advantage of the interestrate cycle is not particularly difficult.

Higher Interest Rates are the result of the Government'sefforts to slow a growing economy in hopes of preventing anappearance of the three headed inflation monster. A quick glanceover your shoulder might remind you of recent times when thegovernment was trying to heal the wounds of a misguided WallStreet attack on traditional investment principles by loweringinterest rates. The strategy worked, the economy rebounded, andWall Street is trying to scramble back to where it was nearlysix years ago. Think about the impact of changing interest rateson your Income during the past five years. Bonds andPreferred Stocks; Government and Municipal Securities; they allmoved higher in Market Value. Sure you felt wealthier, but theincrease in your Annual Spendable Income got smaller andsmaller. Your total income could well have decreased during theperiod as higher interest rate holdings were called away (atface value), and reinvestments were made at lower yields!

How many of you have mental bruises from the realization thatyou could have taken profits during the downward trajectory ofthe cycle, on the very that you now lament over. Thenerve; falling below the price you paid for them years ago. Butthe income on these turncoats is the same as it was in 2004,when their prices were ten or twenty percent higher. This is thework of Mother Nature's financial twin sister. It's like acorns,snowfalls, and crocuses. You need to dress properly for seasonalchanges and invest properly for cyclical changes. Remember thedays of Bearer Bonds? There was never a whisper about MarketValue erosion. Was it the IRS or Institutional Wall Street thattook them away?

Higher rates are good for investors, particularly whenretirement is a factor in your investment decisions. The moreyou receive for your reinvestment dollars, the more likely it isthat you won't need a second job to maintain your standard ofliving. I know of no retail entity, from grocery store to cruiseline that will accept the Market Value of your portfolio aspayment for goods or services. Income pays the bills, more isalways better than less, and only increased income levels canprotect you from inflation! So, you say, how does a person takeadvantage of the cyclical nature of interest rates to garner thebest possible income on investment quality securities? You mightalso ask why Wall Street makes such a fuss about the dismal bondmarket and offers more of their patented Sell Low, Buy Highadvisories, but that should be fairly obvious. An unhappyinvestor is Wall Streets best customer.

Selecting the right to take advantage of theinterest rate cycle is not particularly difficult, but it doesrequire a change in focus from the statement bottom line... andthe use of a few security types that you may not be 100%comfortable with. I'm going to assume that you are familiar withthese investments, each of which could be considered (from timeto time) for a spot in the well diversified Income Portion ofyour Asset Allocation: (1) The traditional individual Municipaland Corporate Bonds, Treasuries, Government Agency Securities,and Preferred Stocks. (2) The eyebrow raising Unit Trustvarietals, Closed End Funds, Royalty Trusts, and REITs.[Purposely excluded: CDs and Money Funds, which are notinvestments by definition; CMOs and Zeros, mutations developedby some sicko MBAs; and Open End Mutual Funds, which just can'twork because they are really "managed by the mob"... i.e.,investors.] The market rules that apply to all of these arefairly predictable, but the ability to create a safer, higheryielding, and flexible portfolio varies considerably within thesecurity types. For example, most people who invest inIndividual bonds wind up with a laundry list of odd lotpositions, with short durations and low yields, designed for thebenefit of that smiling guy in the big corner office. There is abetter way, but you have to focus on income and be willing totrade occasionally.

The larger the portfolio, the more likely it is that you willbe able to buy round lots of a diversified group of bonds,preferred stocks, etc. But regardless of size, individualsecurities of all kinds have liquidity problems, higher risklevels than are necessary, and lower yields spaced out overinconvenient time periods. Of the traditional types listedabove, only preferred stock holdings are easily added to duringupward interest rate movements, and cheap to take profits onwhen rates fall. The downside on all of these is theircallability, in best-yield-first order. Wall Street loves thesesecurities because they command the highest possible tradingcosts... costs that need not be disclosed to the consumer,particularly at issue. Unit Trusts are traditional securitiesset to music, a tune that generally assures the investor of ahigher yield than is possible through personal portfoliocreation. There are several additional advantages: instantdiversification, quality, and monthly cash flow that may includeprincipal (better in rising rate markets, ya follow?), andinsulation from year-end swap scams. Unfortunately, the UnitTrusts are not managed, so there

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are few capital gainsdistributions to smile about, and once all of the areredeemed, the party is over. Trading opportunities, the veryheart and soul of successful Portfolio Management, arepractically non-existent.

What if you could own common stock in companies that manage thetraditional Income and other recognized incomeproducers like real estate, energy production, mortgages, etc.?Closed End Funds (CEFs), REITs, and Royalty Trusts demand yourattention... and don't let the idea of "leverage" spook you. AAA+ insured corporate bonds, and Utility Preferred Stocks are"leverage". The sacred 30-year Treasury Bond is "leverage". Mostcorporations, all governments (and most private citizens) useleverage. Without leverage, most people would be commuting towork on bicycles. Every CEF can be researched as part of yourselection process to determine how much leverage is involved,and the benefits... you're not going to be happy when yourealize what you've been talked out of! CEFs, and the otherInvestment Company mentioned, are managed byprofessionals who are not taking their direction form that mob(also mentioned earlier). They provide you the opportunity tohave a properly structured portfolio with a significantly higheryield, even after the management fees that are inside.

Certainly, a REIT or Royalty Trust is more risky than a CEFcomprised of Preferred Stocks or Corporate Bonds, but here youhave a way to participate in the widest variety of fixed andvariable income alternatives in a much more manageable form.When prices rise, profit taking is routine in a liquid market;when prices fall, you can add to your position, increasing youryield and reducing your cost basis at the same time. Now don'tstart to salivate about the prospect of throwing all your moneyinto Real Estate and/or Gas and Oil Pipelines. Diversifyproperly as you would with any other investments, and make surethat your living expenses (actual or projected) are taken careof by the less risky CEFs in the portfolio. In bond CEFs, youcan get un-leveraged portfolios, state specific and/or insuredMunicipal portfolios, etc. Monthly income (frequently augmentedby capital gains distributions) at a level that is most oftensignificantly better than your broker can obtain for you. I toldyou you'd be angry!

Another feature of Investment Company shares (and please stayaway from gimmicky, passively managed, or indexed types) issomewhat surprising and difficult to explain. The price you payfor the shares frequently represents a discount from the marketvalue of the contained in the managed portfolio. Soinstead of buying a diversified group of illiquid individualsecurities at a premium, you are reaping the benefit of aportfolio of (quite possibly the same) at a discount.Additionally, and unlike regular Mutual Funds that can issue asmany shares as they like without your approval, CEFs will giveyou the first shot at any additional shares they intend todistribute to investors.

Stop, put down the phone. Move into these calmly,without taking unnecessary losses on good quality holdings, andnever buy a new issue. I meant to say: absolutely never buy anew issue, for all of the usual reasons. As with individualsecurities, there are reasons for unusually high or low yields,like too much risk or poor management. No matter how wellmanaged a junk bond portfolio is, it's still just junk. So do alittle research and spread your dollars around the manymanagement companies that are out there. If your advisor tellsyou that all of this is risky, ill-advised foolishness... well,that's Wall Street, and the baby needs shoes.

The final article in this Income Investing trilogy will be onmanaging the Income Portfolio using the Working Capital Model.

About the author:Steve Selengut http://www.sancoservices.com ProfessionalPortfolio Management since 1979 Author of: "The Brainwashing ofthe American Investor: The Book that Wall Street Does Not WantYOU to Read", and "A Millionaire's Secret Investment Strategy"